Economics of International Trade

Exchange rates come in two forms:

“Floating”—here, currencies are set on the open market based on the supply of and demand for each currency. For example, all other things being equal, if the U.S. imports more from Japan than it exports there, there will be less demand for U.S. dollars (they are not desired for purchasing goods) and more demand for Japanese yen—thus, the price of the yen, in dollars, will increase, so you will get fewer yen for a dollar.

“Fixed”—currencies may be “pegged” to another currency (e.g., the Argentine currency is guaranteed in terms of a dollar value), to a composite of currencies (i.e., to avoid making the currency dependent entirely on the U.S. dollar, the value might be 0.25*U.S. dollar+4*Mexican peso+50*Japanese yen+0.2*German mark+0.1*British pound), or to some other valuable such as gold. Note that it is very difficult to maintain these fixed exchange rates—governments must buy or sell currency on the open market when currencies go outside the accepted ranges. Fixed exchange rates, although they produce stability and predictability, tend to get in the way of market forces—if a currency is kept artificially low, a country will tend to export too much and import too little.

Trade balances and exchange rates. When exchange rates are allowed to fluctuate, the currency of a country that tends to run a trade deficit will tend to decline over time, since there will be less demand for that currency. This reduced exchange rate will then tend to make exports more attractive in other countries, and imports less attractive at home.

Measuring country wealth. There are two ways to measure the wealth of a country. The nominal per capita gross domestic product (GDP) refers to the value of goods and services produced per person in a country if this value in local currency were to be exchanged into dollars. Suppose, for example, that the per capita GDP of Japan is 3,500,000 yen and the dollar exchanges for 100 yen, so that the per capita GDP is (3,500,000/100)=$35,000. However, that $35,000 will not buy as much in Japan—food and housing are much more expensive there. Therefore, we introduce the idea of purchase parity adjusted per capita GDP, which reflects what this money can buy in the country. This is typically based on the relative costs of a weighted “basket” of goods in a country (e.g., 35% of the cost of housing, 40% the cost of food, 10% the cost of clothing, and 15% cost of other items). If it turns out that this measure of cost of living is 30% higher in Japan, the purchase parity adjusted GPD in Japan would then be ($35,000/(130%) = $26,923. (The Gross Domestic Product (GPD) and Gross National Product (GNP) are almost identical figures. The GNP, for example, includes income made by citizens working abroad, and does not include the income of foreigners working in the country. Traditionally, the GNP was more prevalent; today the GPD is more commonly used—in practice, the two measures fall within a few percent of each other.)

In general, the nominal per capita GPD is more useful for determining local consumers’ ability to buy imported goods, the cost of which are determined in large measure by the costs in the home market, while the purchase parity adjusted measure is more useful when products are produced, at local costs, in the country of purchase. For example, the ability of Argentinians to purchase micro computer chips, which are produced mostly in the U.S. and Japan, is better predicted by nominal income, while the ability to purchase toothpaste made by a U.S. firm in a factory in Argentina is better predicted by purchase parity adjusted income.

It should be noted that, in some countries, income is quite unevenly distributed so that these average measures may not be very meaningful. In Brazil, for example, there is a very large underclass making significantly less than the national average, and thus, the national figure is not a good indicator of the purchase power of the mass market. Similarly, great regional differences exist within some countries—income is much higher in northern Germany than it is in the former East Germany, and income in southern Italy is much lower than in northern Italy.